As the US becomes the world’s number one producer and, eventually, exporter of oil and gas, it is by no means controversial to say that there is an ever-increasing bullishness on the North American shale plays that have created this unexpected turn of events in such a short period of time.

Despite the resulting frenzy, self-directed investors have good reason to be interested in adding oil and gas stocks to their portfolios because there is still plenty of money sitting on the table. But basic materials stocks typically come with their own cornucopia of risks that are no less complex when limited to those in the oil and gas segment.

Upstream Companies and the Shale Boom

Serious investors looking for healthy returns would do well to avail themselves of at least a basic understanding of the vast and often esoteric-sounding vocabulary of the oil and gas industry, particularly if they are to make astute decisions about how to play the “shale boom”.

Oil and gas companies are classified roughly according to three main operational categories of the industry. Upstream companies handle exploration and drilling, midstream companies are mainly concerned with transporting energy supplies through pipelines and railways, and downstream companies handle the refining and commercial marketing that gets the oil and gas to the pump and into the tanks of America’s vehicles.

Companies do not limit their involvement to strictly one stream, as many dabble to various degrees in all three even if the bulk of their business is mostly tied to just one of them. To add to the potential for confusion, oil and gas services companies like the infamous Halliburton (HAL) make their money through industry-wide contracts. Meanwhile, major integrated companies (“super-majors”) like ExxonMobil (XOM) and Chevron (CVX) , with their market-caps and corporate structures that exceed the GDPs and organizational capacities of many nation-states, are involved in all aspects of the process.

Independent Oil and Gas Drove Shale Production from Early On

Perhaps the most notable components of the industry, and currently the most talked-about, are the independent oil and gas firms. Until roughly the late 1990’s, independent oil and gas companies stayed in business by scooping up the remainder of wells that were no longer of interest to the bigger firms who had already gotten the best out them.

This scenario changed rather dramatically when wildcatter George P. Mitchell revealed that shale formations were not such a wild idea after all. Using a relatively new drilling technology, now popularly known as hydraulic fracturing, he is the individual who is perhaps most responsible for providing an economically gainful means of extracting gas from shale-rock deep beneath the earth’s surface. Concurrent developments in seismic imaging technology provided a fruitful accompaniment, proving as it did that the United States was sitting on a far greater supply of energy resources than had previously been thought.

This resulted in much greater interest in shale plays, and fed right back into further sudden and substantial refinements in exploration and drilling technologies. Independents were essentially the incubator for this technology, and were in the best position to gain from the phenomenon that we now know as the “shale boom”.

This has a great deal to do with the nature of the independent oil and gas industry itself, where the main source of revenue is exploration and production. Unburdened by the other aspects of the business like transportation, refining, and marketing, independents have more time and money to focus on the technology that makes their work easier and more lucrative.

While the Super-Majors Were Away...

But the independents were also the beneficiaries of geopolitics. With the arrival of the new millennium and the subsequent era of the so-called “Global War on Terror”, the heavy hitters of oil and gas found themselves increasingly embroiled in the political quagmires of the typically authoritarian regimes whose countries always seem to sit on vast quantities of reserves.

Majors like Chevron and ExxonMobil, Royal-Dutch Shell ($RDS.A), and others made great efforts to find workable solutions that would satisfy a concatenation of demands ranging from shareholder insistence on replacement reserves, the ever-shifting whims of the kleptocratic regimes with which they were trying to do business, and the global backlash to the US invasion of Iraq in 2003 that breathed new life and vigor into resource nationalism around the world.

With big oil thus distracted, independents were free to pounce on the best US shale plays. One of the main turning points came in 2005, with significant new discoveries being made in Texas’s now highly-prized Barnett Shale, and spread from there. Some of the first companies to get in on the bonanza before it reached its current configuration were Chesapeake Energy ($CHK), now the nation’s largest natural gas producer, along with Cabot Oil & Gas (COG) , and Range Resources (RRC) .

Boom or Not, Crude Is Still the Real Prize

Since that time, the Independent sector has come to be fully dominated by the obsession with shale plays. Be that as it may, investors need to do their best to avoid getting carried away with all of the optimism. Independent companies are still riskier than their major-integrated counterparts, and though shale production continues to increase at astounding rates, it should be kept in mind that most of what is being extracted from the ground is natural gas and liquids that can be refined into natural gas. “Natgas” is nowhere near as profitable as oil, and indeed trades usually for around 20 times less than a barrel of Brent or WTI crude.

Even though independents are not burdened by the same variety of costs as companies working in other parts of the industry, they deal with a much greater amount of risk. Rigs are expensive, and even though the new technology has made possible the ability to puncture a shale formation multiple times from one single platform, shale reserves are notoriously uneven, and have a shorter shelf-life. In other words, the cost of doing business could be pushed much higher than the returns from wellhead production on rather short notice.

Independents Will Provide an Opportunity for the Foreseeable Future, Despite Risks

For the time being, investors would do well to look for companies who have strong production records and, perhaps just as important, derive a significant portion of their revenue from shale oil, or other oil plays (conventional or otherwise). Either way, the independent oil and gas companies are the ones to look at for investors interested in a more or less direct way to play America’s energy renaissance. The US’s newfound position as a world leader in energy production and export makes for a promising horizon for independents in the Shale era. But investors would do well to temper any exuberance with caution, because ultimately independents are, like most energy companies, at the mercy of both geology and the global market.

Shale reserves, for as massive as they may seem at the moment, are still by definition finite, and while it will take at least two decades for the production bonanza to plateau, the party won’t last forever.

In a more immediate sense, an oversupply of natural gas, such as we are starting to see right now for instance, could depress prices to the point that many of the independents who are now frantically perforating the soil of the nation will simply not be able to turn enough of a profit to carry on with their operations. A similar scenario could play out if other major international producers, most likely OPEC, decided to lower the price at which they offer their basket of crudes.

This would not mean the end of the “Shale boom”, but it would mean that the money currently being made would change hands, at which point investors should be prepared to make a quick shift of strategy.

E&Ps Locking in Cash Flows and Sales Prices OPEC’s agreement to cut production levels has kicked off a rush among shale oil companies to hedge their oil price risk above $50 for 2017 and 2018. The number of E&Ps selling oil for delivery next year has pushed the WTI forward curve into slight backwardation after two years of contango. Compare[Read More…]